The Use of Benefit Corporations by Charitable Organizations


For years nonprofit organizations exempt from taxation under Section 501(c)(3) of the Internal Revenue Code (charitable organizations) have dabbled (or sometimes more than dabbled) with profit-generating activities. Mixing for-profit and nonprofit, taxable and tax-exempt entities successfully requires more than a passing knowledge of business structures, governance structures, and tax. Now that the benefit corporation entity form has become somewhat mainstream, the question often arises as to how and when to mix the benefit corporation form within a charitable organization’s structure of activities. This article will provide experienced business law practitioners with an overview of the business, tax, and mission considerations that go into using a benefit corporation within a charitable organization’s enterprise structure. While this article is limited in scope to charitable organizations, the concepts discussed in this article can apply to other tax-exempt organizations.

Benefit corporations are for-profit business corporations that are taxed like any other for-profit corporation—either under Subchapter C of the Internal Revenue Code (the IRC) or Subchapter S of the IRC. While benefit corporations are sometimes referred to as a hybrid between a for-profit entity and a nonprofit entity, this hybridization relates to mission and not to taxation. Benefit corporations, like all for-profit enterprises, have equity holders (i.e., shareholders), who legally have the same financial and economic rights to receive a return on investment as other equity holder any other for-profit enterprise. charitable organizations (in fact all nonprofit organizations) are legally prohibited from having equity holders who have a right to some sort of pecuniary gain or return on investment. These two very important facts about benefit corporations are critical to understand and appreciate when structuring profit generating activities for a charitable organization.

Often a client (or a would-be client) will inquire as to how to “convert” a charitable organization into a benefit corporation or how to “drop-down” a benefit corporation (or a for-profit entity) subsidiary so as to make the charitable organization “economically sustainable” or “independent from charitable donations.” The benefit corporation entity form in and of itself will not make a charitable organization economically sustainable. The benefit corporation entity form merely provides a statutorily created structure and set of rules that allow for-profit businesses to have a mixed purpose. An economically viable “business” plan is still required to make the benefit corporation entity form be of any sort of value. So within the context of charitable organizations, the benefit corporation entity form is merely a structural tool that a charitable organization can consider when planning for and thinking about generating earned income. For purposes of these discussions with charitable organizations, the key point on which to focus is “earned income” or “earned revenue.” Converting a donative charitable organization—a public charity dependent on charitable donations—into a benefit corporation is neither statutorily or practically possible since donative sources of revenue are dependent on a charitable organization being charitable. If, however, a charitable organization has discovered (or imagined) an earned revenue stream not dependent on its charitable tax-exempt status that the charitable organization can develop or maximize, then discussions about how the benefit corporation entity form fits in the mix become possible. Used correctly, the benefit corporation entity form can be a very valuable tool for charitable organizations to either (1) capture earned revenue that the organization can create or generate or (2) create an enterprise that can attract and incent investors to “partner” with charitable organization to create or generate earned revenue. The key to success is using the tool correctly to accomplish the goals of the charitable organization.

The Charitable Organization’s “Tax-Exempt” Reality

Understanding how and when to use to benefit corporation entity form within a charitable organization’s enterprise structure requires a brief explanation of tax-exemption and unrelated business income tax and an understanding as to how these concepts interrelate for charitable organizations.

Tax Exemption Requirements for Charitable Organizations

Organizations that are exempt from income tax under Section 501(c)(3) of the Internal Revenue Code include: “. . . corporations, and any community chest, fund or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes . . . no part of the net earnings of which inures to the benefit of any private shareholder or individual . . .” To better understand how this provision of the IRC is implicated when considering a charitable organization use of the benefit corporation entity form, it is helpful to explain a couple of key tax maxims that impact every charitable organization.

Charitable organizations are only tax-exempt if they are organized exclusively for exempt purposes. To satisfy the Internal Revenue Services’s (IRS) exclusivity test, the charitable organization must have: (1) a written organizational document or charter that expressly describes its charitable purpose(s); and (2) language in its organizational documents that prohibits certain transactions that financially benefit individuals or for-profit entities. The IRS has denied exemption to many would-be organizations claiming to be charitable organizations (typically in the church context) because these organizations had other significant activities that called into question the claimed charitable purpose. For example, the IRS denied exempt status to a church that was operating a restaurant.

A charitable organization must also be operated exclusively for exempt purposes. To obtain and maintain tax exempt status, a charitable organization must satisfy the IRS’s “operational test” that looks at all of the facts and circumstances surrounding the operations of the charitable organization including the organization’s sources of revenue and the nature of its expenses. Generally, most charitable organizations receive a significant part of their gross receipts from charitable sources such as donations and grants. Some charitable organizations operate exclusively by assessing related fees, charging admissions or otherwise selling goods and services related to the charitable purpose (think tuition to a nonprofit school). The key issue with charitable organizations is that the revenue is generated from activities substantially related to the charitable purpose of the charitable organization. Revenue generating activities become questionable (and problematic) when a related revenue activity changes or grows into an unrelated activity. Too much income from unrelated sources may bring into question whether a charitable organization is primarily devoted to tax-exempt purposes or otherwise. When a charitable organization’s revenue generating activity moves too far away from the charitable purpose of the organization, this activity becomes unrelated and moves into the realm of commercial business activity. Unfortunately, no bright line test exists as to how much commercial business activity is too much. The IRS will tend to look carefully at a charitable organization’s commercial business activities where it appears that excessive commercial objectives are being pursued.

No part of a charitable organization’s net earnings can inure to the benefit of any private shareholder or individual. “Inurement” occurs when someone who is a leader, or otherwise exercises control over a charitable organization, takes or uses money or other assets for personal use without due consideration in return. Reasonable salaries and wages are paid in return for services, so they are not considered inurement. The concept of inurement becomes critical with the individual people who lead and operate a charitable organization become involved (and prosper financially) from business activities.

The basic concepts outlined above relate to how a charitable organizations originally obtains tax-exempt status as well as how such organizations maintain tax-exempt status throughout the charitable organization’s life cycle. Unfortunately, tax-exempt status is not a tax status that an enterprise can move in and out of with ease or without very detrimental consequences.

Unrelated Business Income Tax (UBIT)

Whenever the leadership of a charitable organization considers undertaking an earned revenue activity, with or without a new entity in the mix, unrelated business income tax (UBIT) must be considered. The IRS Publication 598 (Rev. January 2015) Tax on Unrelated Business Income of Exempt Organizations provides a relatively user-friendly guide to this very dense topic.

Unrelated business income is income that is generated from a trade or business regularly conducted by a charitable organization that is not substantially related to the performance by the charitable organization of its exempt purpose or function. The term trade or business generally includes any activity conducted for the production of income from the selling goods or performing services. An activity must be conducted with the intent to produce a profit to constitute a trade or business. Business activities of a charitable organization are ordinarily considered regularly conducted if they show a frequency and continuity, and are pursued in a manner similar to comparable commercial activities of nonexempt organizations.

The IRS specifically excludes certain activities from the definition of unrelated trade or business. These activities include: bingo games that comply with certain criteria; a trade or business conducted by a charitable organization primarily for the convenience of its people served; qualified convention or trade show activities conducted at a convention, annual meeting, or trade show; activities related to the distribution of low cost articles incidental to soliciting charitable contributions; the providing of certain hospital services at or below cost by an exempt hospital to other exempt hospitals; a qualified public entertainment activity; qualified sponsorship activities and advertising income; the sale of donated merchandise; and any activity in which substantially all the work is performed by volunteers (without compensation). It is important to know what the IRS excludes from this definition since these activities should be kept within a charitable organization’s operations.

Generally, unrelated business income is taxable, but there are exclusions and special rules that must also be considered. The following types of income (and deductions directly connected with the income) are excluded when determining unrelated business taxable income: all dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and other income from a charitable organization’s ordinary and routine investments (with a whole host of exceptions to these exclusions); income from lending securities; royalties, including overriding royalties; rent from real property, including elevators and escalators (rents from personal property are not excluded); income from research; and income from services provided under federal license.

If a charitable organization directly or indirectly undertakes a trade or business to be regularly conducted that is not substantially related to the charitable organization’s charitable purpose, the charitable organization will be required to pay taxes on that unrelated business income. Too much unrelated business income (and therefore taxation of such income) and the charitable organization risks losing its tax-exempt status.

When contemplating entity types and governance structures for revenue generating activities for a charitable organization, consider the following concepts:

  1. If possible, connect the revenue generating activity to the active charitable purpose of the charitable organization. This connection may help support an argument that the trade or businessis substantially related to the charitable organization’s charitable purpose. The benefit corporation entity form provides a very unique option for connecting activities.
  2. Always consider the activities that have been excluded from the definition of unrelated trade or business. These activities should be conducted within the charitable organization so as to benefit from the exclusion.

Private Inurement and Excess Benefit Transactions

When considering earned revenue activities and structures, in addition to UBIT and tax-exemption, both the volunteer leaders and the professional managers of a charitable organization need to concern themselves with the concept of private inurement and excess benefit transactions. Charitable organizations cannot be operated for the personal wealth accumulation of donors, volunteer leaders or employees. These concepts seem clear when just the operations of the charitable organization are being considered. Unfortunately, these concepts tend to be lost when structuring for-profit enterprises coupled with a charitable organization. If a significant donor, board member or employee of a charitable organization “invests” in a for-profit enterprise, regardless of entity form, connected with a charitable organization for whom that individual serves, inurnment needs to be considered. The same individual serving as an officer in both a charitable organization and coupled for-profit enterprise cause even more issues. Issues of duty of loyalty as well as conflicting, unresolvable fiduciary duty conundrums become real problems. Governance structures and investor mixes need to be carefully considered and reviewed when a charitable organization creates a for-profit enterprise.

More concretely, leaders and managers of charitable organizations who have donors, leaders or paid professional managers who personally benefit in any way from a charitable organization’s for-profit activities need to be mindful of the IRS’s Intermediate Sanction Rules. Technically, Section 4958 of the IRC imposes an excise tax on excess benefit transactions between a disqualified person and a charitable organization. The disqualified person who benefits from an excess benefit transaction is liable for an excise tax. An organization manager that facilitates an excess benefit transaction may also be liable for an excise tax on the excess benefit transaction. Put in context, the following general concepts related to the Intermediate Sanction Rules should are helpful to consider.

An excess benefit transaction is a transaction in which an economic benefit is provided by a charitable organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the charitable organization exceeds the value of the consideration received by the charitable organization. When determining if an excess benefit transaction has occurred, the IRS will include all consideration and benefits exchanged between or among the disqualified person and the charitable organization and all entities it controls. If a charitable organization makes a grant, loan, payment of compensation, or similar payment to a substantial contributor or a disqualified person related to the charitable organization and a controlled or related entity, the arrangement may be an excess benefit transaction.

A disqualified person is any person who was or is in a position to exercise substantial influence over the affairs of the charitable organization at the time and including a look back period. It is not necessary that the person actually exercise substantial influence, only that the person be in a position to do so. Disqualified persons include officers and directors of charitable organizations as well as family members of the disqualified person. Entities controlled by the disqualified person are also disqualified persons. For this purpose, the term control is defined as owning more than 35 percent of the voting power of a corporation, more than 35 percent of the profits interest in a partnership, or more than 35 percent of the beneficial interest in a trust. An organization manager is generally an officer, director or trustee of a charitable organization, or any individual having powers or responsibilities similar to officers, directors, or trustees of the charitable organization, regardless of title.

The excise tax imposed on the disqualified person is 25 percent of the excess benefit that went to the disqualified person. The disqualified person is liable for the tax. And if the excess benefit transaction is not corrected, an additional excise tax of 200 percent of the excess benefit is imposed. The organization manager who facilitated the transaction can be required to pay a 10 percent excise tax on the value of the excess benefit.

Much like UBIT, there are a few maxims related to the Intermediate Sanction Rules that a lawyer structuring a for-profit/charitable organization relationship should keep in mind: (1) if individuals involved with the charitable organization can or will personally benefit financially (either as an investor or as a paid employee or service provider) from the activities of the related for-profit enterprise, the Intermediate Sanction Rules must be considered: (2) keep the governance structures of the charitable organization and the for-profit enterprise completely separate so as to make fiduciary duties clear; and (3) do not cross pollinate senior level/management employees across related entities of different tax species.

Understanding the Intermediate Sanction Rules as well as governance structures of and for charitable organizations and related organizations is critical to structuring for-profit activities that include the leaders and managers of charitable organizations investing in and/or working for or with for-profit enterprises. When a charitable organization considers using a benefit corporation within its enterprise mix these concepts are equally important to consider. The benefit corporation entity form does not remove these concerns and considerations. Thankfully, in several ways, using the benefit corporation entity form when structuring these sort of activities for a charitable organization allows for an opportunity to minimize these concerns.

Working the Benefit Corporation into the Charitable Organization’s Enterprise Mix (or Not)

When structuring for-profit activities connected with or on behalf of a charitable organization, entity options are broad and narrow at the same time. The trusted limited liability company is always an option but the pass through nature of partnership taxation can be both a blessing or a curse for a charitable organization. The same is true with respect to using a taxable nonprofit corporation.

Absent taxation consideration, the benefit corporation entity form, provides a unique opportunity for charitable organizations to structure for-profit ventures. While the taxable nature of a benefit corporation cannot be changed, the customizable mission focused dynamics of the benefit corporation entity form are very useful for contending with the issues outlined above. Under virtually all of the benefit corporation statutes enacted so far, a benefit corporation may include in its certificate or article of incorporation a specific benefit purpose within its declared purposes. The ability to specify an additional social (or charitable) purpose and give priority (or at least parity) to this purpose above shareholder profit maximization allows a charitable organization to potentially scope a benefit corporation entity tightly enough to its charitable purpose and activities to counter UBIT and the other issues outlined above while at the same time creating an opportunity to attractive investors to a venture.

Of course, there are an array of traps and pitfalls that need to be considered when structuring this sort of venture that the benefit corporation entity form cannot erase. Jeopardizing tax-exempt status, UBIT, and intermediate sanctions are very real issues that charitable organizations always need to consider when structuring for-profit activities with or without the benefit corporation entity form.

What the benefit corporation entity form adds to charitable organization for-profit structuring that was not available before its inception is an entity option that includes an external, publically declared mission opportunity as well as a built-in transparency and disclosure system that is robust enough to provide a charitable organization and the public with insight into the operations of a for-profit business venture without having to contend with the full-blown disclosure imposed on tax-exempt organizations.

For practitioners assisting clients with these sorts of transactions, the key point of view should be from the tax-exempt perspective of any charitable organization since the consequences of making a mistake can be dire not only for the charitable organization but also for those individuals that lead them.

This article was originally published in the American Bar Association’s Business Law Today

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